Investing in the age of Trump

Getty/Alex Wong
President Trump's fiscal and de-regulatory agenda was the inflection point for markets at the beginning of 2017 as the promise of fiscal stimulus and deregulation sparked hopes for faster business investment and consumption. The fundamental question for investors is whether the expected fiscal boost, even if it comes in a timely manner, can ultimately lift the U.S. growth rate through greater aggregate demand and productivity. At BNY Mellon Investment Management, we believe that this is one of the central issues for markets in 2017, and signals in either direction are likely to produce outsized market volatility. This uncertainty has prompted us to compile our hopes and fears for markets over the next twelve months as we - like the advisors and investors we serve - seek to understand and navigate potential volatility across all asset classes.

1. The Hopes of the Trump Presidency

Expectations for Higher Growth and Rising Inflation

The economic environment of 2017 has the potential to be a pivot from the "low and slow" backdrop of the post-crisis years. BNY Mellon Investment Management's baseline expectation is that fiscal stimulus and deregulation will encourage investment growth and consumption. The reflationary policies of the administration, coming on top of recent moves in inflation rates are likely to send inflation expectations higher still. Global growth prospects have also improved, propelled by stronger manufacturing activity in China and a gradual uptick in activity in Europe.

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In the U.S., the Federal Reserve (Fed) declared the potential for three rate raises in 2017, signaling that it expects economic growth to be strong enough to withstand further rate increases. The question for investors is whether the Fed allows inflation to overshoot its target of 2% or whether it acts more aggressively to subdue inflation risks.

Implications for Equity Markets

We expect equity markets to appreciate in 2017. A cut in corporate tax rates should increase corporate earnings pushing stocks higher. Even if the underlying growth rate of the economy does not accelerate, expectations of tax cuts alone should be sufficient to support the recent move in equity prices into the next 6-12 months. Current 2016 S&P 500 earnings are projected to come in at $119. If the corporate tax cut gets done at a 25% rate, Bloomberg data show that S&P earnings move to $135-140 for 2017 and $145-150 for 2018, levels already being discounted in the market. Sell-side research estimates that every 5% cut in the corporate tax rate leads to a 4% bump in EPS. (Deutsche Bank, US Equity Insights, December 2, 2016.)

Implications for Fixed Income Markets

With the Fed dot plots suggesting three rate hikes in 2017, and with investor expectations for a reflationary fiscal policy, it seems clear that the 35-year bull market in fixed income is all but over. On a technical basis, fixed income heads into 2017 expensive after years of support by central bank policies. BNY Mellon Investment Management believes that total returns could be hit with higher yields.

The prospect of rising rates signals that investors should diversify fixed income exposure within their portfolios to include less rate-sensitive sectors. We believe that investors should be cautious on longer duration exposure and look for yield in other income-bearing debt instruments. A global strategy in sovereign debt, particularly in the developed economies where sovereign debt continues to be supported by central banks, is one way to maintain portfolio exposure to core fixed income. An unconstrained approach across the credit spectrum in corporate credit will also enhance yield and mitigate drawdown risk.

2. The Fears of the Trump Presidency

Growing Economic and Political Policy Uncertainty

With fiscal policy having the potential to drastically alter the economic landscape and yet with so much still unknown about what will occur, lingering policy uncertainty will be a major theme for global markets. This ambiguity should magnify both upside and downside risks to our expectations. Hanging over this market is the risk that the incoming administration's reflationary policies do not get enacted and/or fail to sustain acceleration in aggregate demand growth. The critical question which threatens the baseline assessment is whether the expected fiscal boost can indeed translate to an increasing U.S. growth rate or whether it is coming at exactly the wrong time, at late-cycle during a period of full-employment. There is also the question of whether a newly hawkish Fed with five new members and a new chair by 2018 could strangle the recovery, putting expensive markets in jeopardy.

Labor Market Concerns

Labor force participation and productivity remain at generational lows and average wages are growing at an anemic rate, all of which suggests that a significant boost to aggregate demand must overcome structural headwinds. The U.S. labor market is already operating beyond the Fed's estimate of full employment, with the headline unemployment rate at 4.6% and wage pressures building amid shortages of skilled labor. Further, the administration's promise to restrict illegal immigration could tighten labor supply in certain industries.

International Volatility

Restricted trade with China and / or Mexico or the imposing of tariffs on imported goods could clip the U.S. growth rate and raise the specter of a global trade war. Brexit is likely to be more disruptive than current markets are allowing for. A Trump rapprochement with Russia could encourage Russian adventurism in the "near abroad" of the Baltic states. Such action will call into question NATO's commitment to these states as well as the credibility of the alliance of a whole.

3. Investing in the Age of Radical Uncertainty

Animal spirits ignited by the promise of fiscal stimulus and de-regulation have sparked the hope of faster growth and consumption in the U.S. While we believe that 2017 should be a year of global economic growth, we also see an environment of emergent risks which historically expensive markets appear to be disregarding.

The prolonged period of high correlations after the global financial crisis were difficult for active managers as it was hard to distinguish performance from the index. Not only were sectors within the equity markets highly correlated, but correlations were also high across asset classes. Since the election, market correlations have declined sharply, as investors rotated into "Trump trades" both within equities and across asset classes.

The recent weakening correlations could mean more opportunities for outperformance by active managers as fundamental research, picking winners and losers, and investing across fixed income sectors should enhance returns.

With policy uncertainty emanating from the pace of rate increases, fiscal implementation and effectiveness, US dollar trajectory, potential trade disruptions, and geopolitical tensions, investors need to spread investment risk across different regions and should prize growth, quality, and inflation protection. Unconstrained equity and bond funds, with the ability to invest globally take advantage of the stronger dollar and potential for increasing global growth. Investors should look to protect portfolios from inflation through real assets, inflation protected bonds, and rising rate credit instruments. To the extent that investors can accept limited liquidity, illiquid alternatives, such as private debt and private equity can enhance real yields through private market investing. Most importantly, investors need to remind themselves that their investments should be well-diversified to withstand any deviations from the reflationary scenario that markets appear to expect in 2017.

Jamie Lewin is Managing Director and Head of Product Strategy, and Alicia Levine is Director of Portfolio Market Strategy, at BNY Mellon Investment Management.